The Value of Valuation

Much like an umbrella, a business valuation is something you don’t think about until you need one. It is typically required when a business is going through a transition. Below are some common questions about business valuations should you ever find your business in transition and in need of a valuation.  

Why would I need a business valuation?

Business valuations play a pivotal role in a multitude of scenarios, spanning from mergers and acquisitions to investment decisions and strategic planning. Below are some reasons why your company might require a business valuation.

• Estate Planning and Wealth Transfer - Business valuations are crucial for estate planning, especially when transferring ownership or assets to family members, heirs, or trusts. A valuation helps determine fair value for tax and inheritance purposes.
• Buying or Selling a Business - In M&A transactions, both the buying and selling parties benefit from having a valuation. This helps the parties negotiate a fair purchase price.
• Shareholder or Partnership Disputes - In cases of disputes among shareholders or partners, a business valuation can help determine the fair value of an ownership interest. This can be used to resolve conflicts or buy out departing owners.
• Divorce Proceedings - During divorce proceedings, spouses may require a business valuation to determine the value of the business for equitable distribution of assets.

My friend told me my business was worth five times earnings. Is he right?

Your friend is likely referencing a rule of thumb. These are informal, general guidelines or benchmarks used as a quick and straightforward method for estimating the value of a business. These rules are typically based on common industry practices, historical transactions, or multiples derived from financial metrics. While they can provide a rough estimate of your business's value, it's essential to understand their limitations and use them cautiously.

Rules of thumb provide only rough estimates and do not consider the unique characteristics of a particular business, such as its growth prospects, competitive advantages, or risk factors. Additionally, different rules of thumb can yield widely varying estimates, leading to inconsistencies in valuation.

So how is the value of my business determined?

The process of determining the value of a business is far from a one-size-fits-all endeavor. It involves a combination of quantitative methodologies, such as financial modeling and data analysis, with qualitative considerations such as a company's market position, growth potential, and operational efficiencies.

There are three approaches to valuation: the Asset-based Approach, Income Approach, and Market Approach.

The Asset-based Approach values a business by calculating the net value of its assets minus its liabilities. Most operating businesses are worth more than their assets, so this approach is most suitable for companies with significant tangible assets like real estate or machinery.

The Market Approach compares the subject business to similar businesses that have recently been sold. It relies on the principle of finding comparable companies and using their valuation multiples (ex: price-to-earnings ratio) to estimate the subject business's value. Selecting truly comparable companies or transactions is critical. Factors such as industry, size, growth prospects, risk profile, and geographic location must align reasonably well with the subject company. It is common to use the Market Approach in conjunction with other valuation approaches to arrive at a more reliable value estimate.

The Income Approach estimates the value of a business by assessing its future income or cash flow potential. The value of a business is directly related to its ability to generate earnings or cash flows in the future. This approach is usually the most relied upon in valuing an operating business. A Discounted Cash Flow analysis is a widely used method in the income approach. It involves estimating the future cash flows a business is expected to generate and then discounting those cash flows back to their present value using a chosen discount rate. The accuracy of the income approach depends on the quality of the cash flow projections. Projections should be realistic, based on historical performance, industry trends, and a thorough understanding of the business.

Do I add the value of real estate to the value of my business?

If your business owns the real estate it operates from, the value of the real estate is typically included in your overall business valuation. This is especially true if the real estate is integral to your business's operations, such as a manufacturing facility, retail store, or office space.

In some cases, a business may own real estate that is not directly used in its operations but is held as an investment. In such cases, the value of the real estate would be considered separately and added to the business's operating value.

If an asset is owned by your company and is used in your business to generate cashflow, its value is included in the value of operations. You are not allowed to double count the value of the asset and the benefit it provides. In other words, you can’t have your cake and eat it too.

How do you account for intangible assets in a business valuation?

Intangible assets are assets that lack a physical presence but hold value for a business. Examples include patents, copyrights, tradenames, and goodwill. The valuation of intangible assets can be complex and subjective. While it is possible to value individual intangible assets separately, most business valuations do not separate them out. Similar to real estate, the value of intangible assets is accounted for in the business valuation. They are a crucial component of a company's overall worth and can significantly impact a business's overall value by contributing to the company's competitive advantage, revenue generation, and growth potential. Intangible assets can also mitigate risk by providing a competitive edge or protecting a business's market position.

How can I increase the value of my company?

The most straightforward ways to increase the value of your company are by increasing revenue and controlling costs. Focus on growing sales and diversifying revenue streams. Explore new markets, expand product lines, or offer additional services to attract more customers. Implement cost-saving measures to improve profitability. This may involve renegotiating supplier contracts, optimizing inventory management, or streamlining operations. Looking at this another way, if your business is valued at five times earnings, every dollar you drop to the bottom line will increase your valuation by five dollars.

Other ways to increase the value of your company include the following:

• Working Capital Optimization - Efficiently manage working capital by balancing the levels of current assets and liabilities. Avoid overstocking inventory and expedite accounts receivable collections.
• Intellectual Property Protection - Safeguard intellectual property assets, such as patents, trademarks, and copyrights. Protecting these assets can increase their value and generate licensing income.
• Customer Contracts and Retention - Secure long-term customer contracts or subscription agreements. Predictable revenue from recurring customers can enhance your business's value.
• Market Expansion - Explore new markets or geographic regions to expand your customer base. Develop marketing strategies tailored to target audiences in those areas.
• Customer and Client Relationships - Nurture strong customer relationships to encourage repeat business and referrals. Happy and loyal customers can enhance your company's reputation and long-term prospects.

Increasing the value of a company often requires a long-term perspective and a commitment to continuous improvement. Business owners should regularly assess their strategies and adapt to changing market conditions to maximize the value of their business over time.